Proposition K - Business Taxes

Voter Guide

November 1, 2004

This measure appeared on the November 2004 San Francisco ballot.

What it does

Proposition K is an ordinance introduced by the mayor and placed on the ballot by the Board of Supervisors that would change the way the City taxes businesses. It would add a 0.1 percent tax on gross receipts in addition to the current payroll tax. In addition, it would extend the payroll tax to certain types of partnerships and other entities to which it does not currently apply. The measure is designed to generate $25.2 million during the remainder of fiscal year 2004-05 and $43.1 million in subsequent full years, and is one component of effort to close the City's budget shortfall.

Why it is on the ballot

There are approximately 65,000 businesses that currently are registered with the City, less than 10,000 of whom are required to pay business taxes (the remainder of which are small businesses exempt from paying the taxes). In the past, San Francisco businesses paid either the payroll tax (which is calculated as a percentage of compensation to employees) or the gross receipts tax (which is a percent of total revenues to the business). Each business was required to calculate its tax liability under both taxes, and pay the higher of the two. However, in the late 1990s a number of businesses sued the City claiming the dual tax structure was unlawful because different companies were subject to different taxes, and therefore violated the Constitutional interstate commerce provisions. In 2000, the City settled with the companies and the voters approved Proposition I, which eliminated the gross receipts tax and established the payroll tax as the City's sole business tax. Last year, the payroll tax generated approximately $280 million in revenues to the City. Since the shift in the City's tax structure there has been a good deal of public debate regarding what form the City's business tax should take over the long term. Many individuals and groups have urged a shift from the payroll tax to the gross receipts tax, on the grounds that it would be relatively easy to implement and have less harmful effects on the city's economy.

Certain types of business organizations, called "pass-through entities," do not pay business taxes in San Francisco . These entities include partnerships, limited-liability corporations, and limited-liability partnerships. They are organizations that have a particular legal status with regard to state and federal tax policy and liability issues. Many of these pass-through entities are law firms, accounting firms, and other professional service providers. Proposition K would subject these firms to a local business tax for the first time.

Pros

Those who support Proposition K state:

Although a business tax increase is not desirable, it is a necessary step to help the City close its chronic budget shortfalls.

We need to raise taxes, and it is preferable to do so with a gross receipts tax, because it does not discourage employment and wage growth like the payroll tax. The addition of the gross receipts tax represents a shift toward a tax that will be better for the city's economic health in the long run.

The gross receipts tax measure allows for flexibility. It can be reduced by the controller if it brings in more revenue than is needed to close the budget gap. In addition, it sunsets after four years, which means it is not permanent.

There is no legitimate reason for partnerships, limited liability partnerships, and limited liability corporations to be excluded from the payroll tax. These businesses benefit from the public services provided by City government, and should be asked to pay their share of the costs.

Cons

Those who oppose Proposition K state:

Increasing business taxes will hurt the economy by driving away or harming businesses that are already having a difficult time in a slow economy.

While different businesses prefer payroll or gross receipts taxes, this measure is the worst of all possible worlds for businesses because they must pay both. Some small businesses sought an increase in the payroll tax as an alternative.

The measure imposes a double tax. Payroll is paid out of a firm's gross receipts, therefore the measure taxes businesses twice on the same money.

The small-business exemption only applies to businesses with less than $500,000 in gross receipts. This level is too low. Many of what most people consider to be small businesses have substantially higher gross receipts, and should be exempted.

The City should gather data about how much revenue a gross receipts tax will generate before it imposes one. This would eliminate the uncertainty over whether the tax will exceed its targeted revenue level.

Extending the payroll tax to partnerships and other business types will be challenged in court and may be illegal. The measure can be viewed as imposing an income tax on the partners in these businesses. But only the federal and state governments--not the City--have the legal authority to levy an income tax.

SPUR's analysis

Gross Receipts Tax

Under Proposition K, businesses would pay a 0.1 percent gross receipts tax in addition to the 1.5 percent payroll tax the currently pay (the payroll tax rate remains unchanged). There is an exemption from the proposed gross receipts tax for small businesses that have less than $500,000 per year in gross receipts. The additional tax is targeted to raise roughly $30 million in revenues per year, and the 0.1 percent rate was chosen as a level that is estimated to generate that amount. However, because the City lacks precise information on the total gross receipts of tax-paying businesses, there is a possibility that this estimate is incorrect and the total revenues generated will be more or less than $30 million. If, after the first full year of the new tax, the controller determines that the tax raised more than that amount, the tax rate would be incrementally decreased in subsequent years to a rate that would generate $30 million annually. The measure provides that the new tax will apply until the 2008 tax year, at which point it will expire.

The gross receipts tax and payroll tax also have different economic implications for the City as a whole. Generally speaking, if a behavior is taxed, people will be less inclined to engage in that behavior. Under a payroll tax, if a business adds jobs or increases salaries, its tax burden grows. Thus, many feel that the payroll tax serves to discourage job creation by making adding jobs more expensive relative to other options, such as investing in new technology. Under the payroll tax businesses face at least some disincentive to add jobs and salary. The gross receipts tax, on the other hand, does not have the same dampening effect on job growth. However, because the tax is based only on revenue without regard to expenses, it can be hard on businesses with high revenues and relatively low profit margins. These businesses will pay a large amount in taxes because they have a lot of money coming in, but most of that money is paid back out in expenses. This means the gross receipts tax can cut deeply into their already relatively small profits. In addition, a gross receipts tax reduces the amount of money a business gets to keep out of every dollar coming in, which affects behavior by reducing the overall incentive to do business in the city. So, while both types of taxes affect business incentives, the payroll tax has the additional impact of creating a marginal disincentive to add payroll spending.

From the perspective of individual businesses, whether they prefer a gross receipts tax or a payroll tax depends on a number of factors, but a primary one is how much of their expenses consist of payroll. If a business is very labor-intensive, meaning it spends a large portion of the money it takes in on employee labor, it may have to pay more under the payroll tax, and thus prefer the gross receipts tax. On the other hand, a business that has a smaller payroll relative to its overall revenue would likely pay more under the gross receipts tax, and thus prefer a payroll tax.

Application of Payroll Tax to Partnerships and Other Businesses

Proposition K would extend the payroll tax, at its current 1.5 percent rate, to certain businesses including partnerships, limited-liability partnerships, and limited-liability corporations that are currently not required to pay the tax. The controller estimates that this change will result in about $13.5 million in new revenues in fiscal year 2005-06. Many of these businesses are legally distinct from corporations because they serve to distribute earnings among partners rather than having traditional payroll structures. In the past, these earnings have not been considered payroll, and therefore have not been subject to the payroll tax. The stated rationale for this change is that, despite their distinct legal status under state and federal law, these businesses for all intents and purposes behave much like other businesses, and therefore should be subject to local payroll taxes.

General Implications of Raising Business Taxes

It is often claimed that higher business taxes, whether in the form of payroll or gross receipts, will discourage businesses from locating in San Francisco and force some of those already here to leave. There is clearly some truth to the claim that tax levels affect business-location decisions. However, it is not quite so simple. Businesses also respond to a city's amenities, such as quality of life, schools, and the demographics of its population. Often these factors affect a firm's ability to attract the right kinds of customers and employees. The services provided by local government, including safety, education, parks, transportation, and others have an effect on business-location decisions as well.

While raising business taxes is not ideal, it is a necessary step to address budget problems that the City will face for the foreseeable future. In order to deal with this budget problem, the City has taken a number of steps including reducing the number of City employees, cutting other government expenses, raising fees, and placing a sales tax increase on the ballot as well (Proposition J). It is very important that San Francisco remain conscious of the affects of its tax policy on businesses in the city. However, this measure is one part of a larger solution that asks everyone--not just businesses--to contribute.

In addition, the measure is a first step away from the payroll tax, and toward the more economically desirable gross receipts tax. Although some individual businesses may prefer the payroll tax, on balance most businesses and the City's economy should benefit from a shift toward a tax that does not discourage job creation and wage growth to the extent that a payroll tax increase would.

The extension of the payroll tax to cover partnerships and other previously excluded businesses is another reasonable component of this broad-based effort to cut costs and generate much-needed revenue for the City.

SPUR believes that the first step toward solving a budget problem should be to find ways to make government operate more efficiently. However, because of the magnitude of this budget shortfall and those projected for the next several years, efficiencies will not be enough. The City needs additional revenue, and Proposition K is part of a balanced approach to stave off massive public service cuts.